UK INVESTORS’ PERCEPTIONS OF AUDITOR INDEPENDENCE

Abstract

The auditor‟s role in society is that of validating the truth and fairness of financial statements.

If owners of organisations doubt the auditor‟s independence, financial statements will lack

credibility. This questionnaire-based study investigated how investors perceive three

potentially independence-impairing auditor-client relationships: the joint provision of audit

and non-audit services, an audit firm‟s economic dependence upon a client and long term

relationships between auditor and client. The objective was to determine whether, after a

series of high-profile corporate collapses, owners retain faith in the integrity of the auditor.

The results suggest that economic dependence and the provision of non-audit services are

perceived as greater threats to auditor independence than long-term relationships between the

auditor and client.

Keywords:

Auditor Independence, Investors’ perceptions

UK INVESTORS’ PERCEPTIONS OF AUDITOR INDEPENDENCE

Introduction

The UK House of Commons Treasury Committee (2009:76) stated that „public confidence in

the operation of capital markets depends in part on the credibility of corporate reports

produced by boards of directors‟. The auditors‟ role in society is to assure interested third

parties that these corporate reports and financial statements are a true and fair reflection of

company performance. In order to perform this role, it is essential that auditors are

independent of the client company (Lavin, 1977:237). If the owners of organisations doubt

the auditors‟ independence, financial statements will lack credibility, which could lead to the

„abrupt and arbitrary withdrawal of capital from suspect businesses‟ (ABI, 2002:3). Even

though independence lies at the heart of the auditing profession, independence concerns can

be traced back to the nineteenth century (Chandler & Edwards, 1996). Since then, the

accounting profession has found it difficult to produce a system of standards which

eliminates conflicts of interest and protect auditors‟ independent mind set. In the UK,

concerns about auditor independence were heightened as a result of the scandals and

corporate collapses of the 1980s and 1990s (e.g. Maxwell, BCCI, Polly Peck, Barings Bank

and Lloyd‟s of London). These scandals provoked substantial academic interest in the subject

of auditor independence (see for example Firth, 1980 & 1981, Shockley, 1981, Dykxhoorn &

Sinning, 1982, Pany & Reckers, 1983 & 1984, Knapp, 1985, Lindsay, Rennie, Murphy &

Silvester, 1987, Lindsay, 1989 & 1990, Gul, 1991 and Wines, 1994) and caused some

changes to the structure and pronouncements of regulatory bodies.

Much has changed in the audit environment since these studies were conducted such as the

high-profile accounting scandals of Enron, WorldCom and Tyco and a series of mergers and

the failure of Andersen in 2002, which reduced the “Big Eight” audit firms to a “Big Four”.

In 2002 the Sarbanes-Oxley Act was introduced in the USA to ensure that auditors would be

seen to be in a position of complete independence. In the UK, the Auditing Practices Board

(APB) issued „Ethical Standards for Auditors‟ in 2004 (updated in 2008/09). While

remaining principles-based in nature, these standards are less permissive than previous

guidelines, especially when combined with an enhanced role for a company‟s audit

committee in overseeing auditor independence issues and the threat to auditors of regular

inspections from the Professional Oversight Board‟s Audit Inspection Unit.

Despite these regulatory initiatives, fundamental questions over auditors‟ ability to live up to

the service ideal of professional integrity remain. For example, in the wake of the recent

banking crisis the UK House of Commons Treasury Committee (2009:77) commented that

„the fact that the audit process failed to highlight developing problems in the banking sector

does cause us to question exactly how useful audit currently is‟.

In the light of high-profile corporate collapses and further concentration of the UK audit

market, the objective of the current study is to gain an insight into how the owners of

organisations perceive audit work and auditor independence. This questionnaire-based study

was conducted in the wake of the highly publicised Enron scandal and focuses specifically

upon investor perceptions of the auditor-client relationships that arguably contributed to

Andersen‟s failure to prevent Enron‟s questionable accounting practices. These relationships

are, the joint provision of audit and non-audit services (in 2000 Enron paid $27 million to

Andersen for non-audit services), an audit firm‟s economic dependence upon a client (on top

of non-audit fees, in 2000 Andersen also received $25million in audit fees from Enron) and

long-term relationships between auditor and client (Andersen had audited Enron since

Enron‟s formation in 1985).

These three auditor-client relationships created a bond between Andersen and Enron: the

length of tenure resulted in familiarity building up between the two parties, whilst the size of

audit and non-audit fees that Andersen was receiving made the auditors reluctant to risk

losing such a lucrative client. Furthermore, these auditor-client relationships were highlighted

by the UK‟s Auditing Practices Board in 2004 as causing self interest, self-review,

familiarity, intimidation, management and advocacy threats to auditor independence, but

since then have not been investigated widely by UK researchers. The International Federation

of Accountants (IFAC) also acknowledges, in its Handbook of International Auditing,

Assurance and Ethics Pronouncements (2008), that these three relationships pose a threat to

auditor independence. Therefore the contribution of this study is the provision of a unique

and up-to-date account of investor perceptions of auditor independence with a specific focus

upon whether investors perceive the UK‟s APB „Ethical Standards for Auditors‟ to be

stringent enough. This research is of value to those academics and accounting professionals

currently debating the role of the auditor and to those policymakers considering UK

accounting regulation. Furthermore, given that scandals such as Enron and WorldCom

occurred outside the UK, the findings of this research should also have international appeal

and especially be of interest to American academics and policymakers.

The remainder of the paper is organised as follows: the next section reviews relevant

literature from which hypotheses are developed. The methodology and survey design will

then be discussed, followed by the results and conclusions of the research.

Literature Review and Hypothesis Development

Both academics and practitioners have struggled to define precisely what is meant by auditor

„independence‟. Although many definitions of independence exist, the current study is guided

by DeAngelo (1981:116) who argues that an auditor is independent when on discovering a

breach of accounting regulations „the auditor will report the breach‟. The following section

provides an overview of the research into perceptions of auditor independence focussing in

particular on the areas of economic dependence, the provision of non-audit services and long

audit tenure. The study builds upon the previous UK perceptions-based work of Firth (1980

&1981) and Beattie, Brandt and Fearnley (1999), who both sampled the perceptions of users

and preparers of financial statements of different types of auditor-client relationships. As the

audit market has changed materially since those studies were conducted, it is expected that

current perceptions of auditor independence may differ from those previously recorded.

The amount and method by which audit fees are paid to audit firms can create a conflict of

interest for auditors. In the case of Enron, it is argued that audit fees represented a substantial

proportion of the local Andersen audit office‟s earnings even without the additional non-audit

service fee revenue (Haber, 2005:12). The APB identifies this auditor-client relationship as

potentially independence-impairing, and under its Ethical Standards for Auditors bans audits

being undertaken on a contingent fee basis, stipulating that if audit fees are outstanding or if

audit fees from one client regularly exceed 10% of the annual fee income of the audit firm,

the auditor should withdraw from the audit. Some commentators argue that third party

perceptions of auditor independence are damaged when an audit firm receives a substantial

amount of its income from one client (see for example the UK based questionnaire evidence

reported by Firth (1980, 1981), and Beattie et al. (1999)). International studies based on the

results of questionnaires also confirm that economic dependence damages auditor

independence perceptions. For example, Lindsay et al (1987) confirmed this finding in

Canada, Gul (1991) in New Zealand and Alleyne and Devonish (2006) in Barbados. Other

research methods have also been employed, with similar findings. Using a case study

approach, Teoh and Lim (1996), found that large audit fees received from a single audit client

affected auditor independence perceptions of Malaysian accountants. By using the cost of

equity capital as a proxy for investor perceptions of the credibility of financial reports,

Khurana and Raman (2006) found (through regression analysis) that investors perceived

client dependence negatively, because a positive association between auditor fees and cost of

equity capital was established. Gosh, Kallapur and Moon (2009) found that client importance

ratios (ratio of fees from one client to the audit firm‟s total revenue) were significantly

negatively associated with the earnings response coefficient. From these findings Gosh et al.

(2009:383) argued that „a negative investor perception exists toward high levels of client

importance‟. Conversely, Higgs and Skantz (2006) argued that companies who pay relatively

high audit fees are actually signalling audit quality to investors, giving investors greater faith

in the company‟s audited financial statements.

As much of the UK perceptions-based work in this area was conducted in the 1980s and

1990s, this current research will provide an updated account of perceptions of economic

dependence. It is noted that economic dependence can refer to a number of different

situations. The current study will examine the effects of economic dependence at local audit

office level in light of the apparent dependence of Andersen‟s Houston office upon Enron for

much of its audit and non-audit income.

The paper starts with the a priori assumption that each of the auditor-client relationships will

negatively impact upon investor perceptions of auditor independence:

H1: Where an auditor is dependent upon a client for over 10% of its income, it will not be

perceived as independent.

The conflict of interest which economic dependence creates is further exacerbated when

auditors provide their clients with non-audit services. Mautz and Sharaf (1961) state that the

only way for auditors to maintain an appearance of independence is to engage in auditing

without providing any non-audit work. Whilst the APB has placed widespread restrictions

upon the provision of non-audit services in its Ethical Standards for Auditors, it has stopped

short of introducing a widespread ban on the practice. Before undertaking non-audit work,

auditors must now consider whether an informed third party would consider the objectives of

the non-audit work as consistent with those of the audit. The auditor must assess the threats

that such work may pose to auditor independence and assess the effectiveness of the

safeguards in place to eliminate these threats. The APB state that if the threats that non-audit

work poses to auditor independence cannot be safeguarded against, the auditor must not

undertake that work, or should withdraw from the audit itself.

Both the UK House of Commons Treasury Committee and the Pensions Investment Research

Council have expressed significant concerns about the practice of auditors acting as

consultants. The UK House of Commons Treasury Committee (2009:84) stated that „we

strongly believe that investor confidence, and trust in the audit would be enhanced by a

prohibition on audit firms conducting non-audit work for the same company‟. Survey

research of UK finance directors and audit partners conducted by Beattie et al. (1999) found

that, consistent with the UK survey conducted by Firth (1980), both groups were concerned

about the effects of the provision of non-audit services upon auditor independence. Canning

and Gwilliam (1999) used a multi-method approach (of questionnaires and interviews) to

determine the effect which the provision of non-audit services had on perceptions of auditor

independence in the Irish commercial environment. The population of the study comprised

the main users of financial statements: corporate lenders, investment managers and financial

analysts. The results showed that over two-thirds of respondents agreed that auditor

independence decreased when the same personnel provided both audit and non-audit services.

Another questionnaire-based perceptual study was conducted by Quick and Warming-

Rasmussen (2005) in Denmark. Questionnaires were sent to state-authorised auditors,

managing directors, bank loan officers, private shareholders and business journalists. The

results showed that all of the groups except the auditors and managing directors viewed an

impairment of independence when an auditor provides both audit and non-audit services to a

client. Quick and Warming-Rasmussen (2005) concluded that independence in appearance

was damaged by the provision of non-audit services. As in the current study, the Danish

questionnaire also tested perceptions of individual non-audit services and found that those

non-audit services which were perceived to be closer to auditing activities (such as

accounting-related services) were perceived more favourably than those services which least

resembled auditing.

In a similar survey, based on German investors, Quick and Warming-Rasmussen (2009)

found that there was a significant level of concern about the provision of non-audit services.

The investors were asked to indicate their perceptions of 19 different non-audit services. Of

these services, only two (accounting information systems and forensic services) did not cause

investors concern.

A US survey conducted by Gaynor, McDaniel & Neal (2006) of audit committee members

provided indirect evidence that auditor-produced non-audit services damaged investors‟

perceptions of auditor independence. The survey revealed that audit committee members

were less likely to allow joint provision of audit and non-audit services, after the SEC ruled

in 2002 that audit committees had to pre-approve and disclose all auditor-produced non-audit

services, even if those services actually improved audit quality. It appears that the committee

members surveyed believed joint provision could damage investor trust.

Using a case study approach, Solomon, Reckers, & Lowe (2005) focused on the perceptions

of law students of the provision of non-audit services. These students had to evaluate the

credibility of a company‟s financial statements and state whether, in their opinion, the

company would be a good investment. The students were given different case studies, some

detailing that the company paid audit fees only and some in which the company also received

non-audit services from its auditor. The results showed that the students expressed a greater

willingness to invest in companies that received audit services only.

Brandon, Crabtree & Maher (2004) focused their study on bond ratings, and in particular

bond analysts‟ perceptions of auditor independence in relation to non-audit service provision.

The results of these tests showed that bond rating analysts acknowledged the proportion of

non-audit fees to total fees provided by an auditor and incorporated the information into the

bond ratings as a „significant concern‟ (Brandon et al., 2004:98). Brandon et al. (2004) were

correct in hypothesising that those companies which purchased higher non-audit services

from their auditor generally received a lower bond rating.

Krishnan, Sami, & Zhang (2005) examine whether there is an association between levels of

non-audit service purchases and the earnings response coefficient (ERC). The ERC is a

surrogate for investors‟ perceptions of auditor independence, because it measures perceptions

of earnings quality. The study was in response to SEC Rule S7-13-00, implemented in 2001,

which required companies to disclose non-audit fees. Before then, investors were aware only

of estimates of non-audit service payments. The association of non-audit service purchases

and ERCs was examined over three quarters of 2001 directly after the SEC ruling. The results

highlighted that there was investor concern over non-audit service provision, because ERC

was lower for companies with high non-audit fee ratios. In a similar study, Gosh et al. (2009)

argued that non-audit fee ratios were not associated with ERC.

New Zealand evidence, based on financial report data from the top 200 companies, suggested

that there was no link between levels of non-audit fees and an auditors‟ propensity to issue a

qualified audit opinion (Hay, Knechel and Li, 2006). Despite that evidence, Hay et al. (2006)

warned that it was possible that non-audit fees would still demonstrate a lack of auditor

independence in appearance to the public.

In contrast to the above research, a number of perceptual studies implied that non-audit

service provision did not impair auditor independence. In survey of 49 bank-lending officers

in New Zealand, Gul (1989) reported that there was no relationship between the provision of

non-audit services and negative perceptions of auditor independence. The bankers actually

had more confidence in those auditors who provided non-audit services.

In a case study, Reckers and Stagliano (1981) attempted to examine the perceptions of

different financial statement user groups of joint provision. The participants were asked to

rate how they perceived different levels of non-audit service provision to affect auditor

independence. The sample of participants included 50 financial analysts (sophisticated

financial statement users) and 50 MBA students (relatively unsophisticated financial

statement users). The sample was chosen deliberately in order to test the hypothesis that

concern about non-audit service provision decreases as accounting knowledge and

sophistication increase (a hypothesis that is re-tested in the current study). The results of the

survey showed that in each case, the MBA students seemed to have less confidence in the

auditor‟s independence than the financial analysts did. The finding supported the hypothesis

that naïve financial statement users have less confidence in auditor independence than

sophisticated users. However, both groups displayed a high level of confidence in auditors‟

ability to remain independent, in each of the cases of non-audit service provision. It was

concluded that the provision of non-audit service did not damage perceptions of auditor

independence.

Also using a case study approach, Pany and Reckers (1988) studied US loan officers

reviewing loan applications. Those who were given situations where the client firm received

non-audit services at 25% of the audit fee (as compared with those at zero, at 60%, and at

90% levels), were most likely to grant a loan. It could be inferred that the limited level of

non-audit services gave the loan officer greater confidence in the auditors‟ independence.

Furthermore, in a study of 776 UK finance directors, Hussey (1999:193) found that the

majority of the respondents „were content to permit auditors to undertake other work‟.

Mishra, Raghunandan, & Rama (2005) found that investor perceptions of auditor

independence varied with the type of non-audit services being provided. Results of their

study showed that investors displayed more concern for tax and other services (and voted

against the ratification of auditors who supplied these services) than for audit related services

There appears to be little consensus in the extant literature on the impact of non-audit service

provision on perceptions of auditor independence, with results of a UK questionnaire based

study of finance directors, audit committee chairs and audit partners suggesting that not

providing such services may have a negative impact upon audit quality (Beattie, Fearnley &

Hines, 2009). In light of the controversy in this area, Krishnan et al. (2005) call for more

research to be done in this area:

H2: Joint provision of audit and non-audit services will impair perceptions of auditor

independence.

The threat which economic dependence poses for auditor independence is likely to be even

greater if the same auditor audits a client for a lengthy period. For example, Brody and

Moscove, (1998:33) argued that auditors might become less challenging over time, causing

the audit process to become „stale‟. This assertion is supported by US and Australian

evidence that suggests audit quality declines as length of tenure increases (see Deis and

Giroux, 1992; Coupley and Doucet, 1993; Nagy, 2005 and Carey and Simnett, 2006). Some

commentators believe that the introduction of mandatory audit firm rotation would result in

enhanced audit quality, as new auditors would provide a „fresh perspective‟ (ICAEW,

2002:3). However, it has also been argued that auditor independence is more likely to be

impaired in the early years of a relationship when auditors are still unfamiliar with their client

(see for example, St. Pierre and Anderson, 1984). In its Ethical Standards for Auditors, the

APB acknowledges the threat which long tenure can pose for auditor independence. The

standards stipulate that audit firms must monitor the length of time that key personnel serve

as members of the audit engagement team, and engagement partners must rotate after five

years with other key audit personnel rotating after seven years. The standards do not require

mandatory audit firm rotation.

Perceptions-based studies have produced conflicting evidence on the effect of long tenure.

UK survey-based studies by Firth (1980 & 1981) and Shockley, (1981) and Hussey and Lan

(2001) all reported evidence that third-party perceptions were not damaged by long tenure.

Hussey and Lan (2001) found that the majority of the UK finance directors sampled were not

in favour of compulsory audit firm rotation. Firth (1981) argued that long tenure meant faster

audit completion, reduced audit fees, and increased auditor expertise.

However, results of a Texas-based survey conducted by Knapp (1991), suggested that length

of audit tenure influenced audit committee members‟ assessments of audit quality. Audit

quality was positively correlated with five-year tenure, but negatively correlated in

subsequent years. Knapp (1991:47) argued that audit committee members perceived a

learning curve effect in the early years of the relationship which gradually improved quality,

but „complacency on the part of the auditor, over-reliance on the client and less rigorous

audits may account for the erosion of perceived audit quality as audit tenure becomes

relatively lengthy‟. Other survey-based studies, one involving Malaysian loan officers

(Bakar, Rahman, & Rashid, 2005) and one of users and preparers of financial statements in

Barbados (Alleyne and Devonish, 2006), found that the mandatory rotation of auditors would

promote the perception of auditor independence. A US survey of bank loan officers‟

perceptions of audit firm rotation found that 53% of the sample agreed that mandatory audit

firm rotation should be introduced (Daniels and Booker, 2009).

The studies in this area do not provide current evidence of UK investors‟ perceptions of long

audit tenure or mandatory audit firm rotation. The current study responds to Knechel and

Vanstraelen‟s (2007:113) concerns that the effects of long tenure on auditor independence

have not been „completely answered by extant research‟. The study hypothesises that:

H3: Perceptions of auditor independence will be impaired by client employment of the same

auditor for over five years.

The study will fill the gaps identified in the literature by providing a post-Enron account of

the ways in which owners, the most important users of audited financial statements, view

auditor independence. In addition to the main hypotheses laid out above, a number of

background variables will be examined in order to determine whether they have an effect

upon investor perceptions of auditor independence. The following hypotheses are stated in

their null forms:

The level of an individual‟s understanding of accounting was first tested by Reckers and

Stagliano (1981) who found that those expressing the greatest concern about auditor

independence were the individuals who had a less „sophisticated‟ understanding of

accounting. However, evidence provided in studies conducted by Pany and Reckers (1983 &

1984) and Bartlett (1993) has since rejected the idea that level of accounting knowledge

affects perceptions of auditor independence. The present study will examine this debate:

H4: There is no difference between investors with and investors without accounting

qualifications in their perceptions of auditor independence.

The study will provide an original comparison of the views of institutional and private

investors, previously overlooked by researchers. Since this comparison of investor

perceptions is original in nature, there is no formal theory to guide hypothesis development.

However, as private and institutional investors have very different motivations for investing,

it is expected that differences will be detected in their perceptions of auditor independence.

Titard (1971) suggested that institutional investors may be more concerned about the issues

relating to auditor independence than private shareholders because institutional investors‟

decisions are of greater significance and higher profile than those made by private investors.

However, private investors have to make decisions about their own money and could stand to

lose income as a result of audit failures. Furthermore, it is likely that private shareholders will

have very little contact with the company in which they invest. The current research will

compare private and institutional investor perceptions:

H5: There is no difference between institutional and private investors in their perceptions of

auditor independence.

It is possible that men and women will view the three potentially risky auditor-client

relationships in different ways. There is a lack of research into gender specific investment

behaviour, although Martenson (2007) argued that the few studies which have been

conducted found that gender differences did exist in investment behaviour. Studies conducted

by Hudgens and Fatkin, (1984), Zinkhan and Karande, (1991), Powell and Ansic, (1997),

Levin, Snyder, and Chapman (2001), Brooks (2002) and Martenson, (2007) have suggested

that, in business and financial situations, women are more risk-averse than men. Conversely,

Masters (1989) suggested that there was no difference between men and women in decision-

making and risk-taking. Gender differences in perceptions of auditor independence will be

tested in this study:

H6: There is no difference between men and women in their perceptions of auditor

independence.

Method and Sample Selection

As the owners of organisations and the main users of financial statements, investors were the

sample selected for investigation. The results of the survey highlighted investors‟ reliance

upon the (audited) financial statements produced by the companies in which they invest. Of

those sampled, 95.4% of institutional investors indicated that they read company reports

including 69.7% who read them „thoroughly‟. Similarly, 92.7% of the sample of private

investors claimed to read company annual reports, including 35.2% who claimed to read

them „thoroughly‟.

In 2004, a pilot questionnaire was sent to 150 institutional investors to determine perceptions

of non-audit services. This pilot was important in informing the format and subject matter of

the current questionnaires. The final versions of the two questionnaires were further revised

in light of advice and suggestions from colleagues.

The questionnaire design varied slightly between the private and institutional investors in

order to acknowledge that the institutional investors, as chief executives (or their nominees),

were more likely to be financially literate and familiar with auditor independence issues than

the private investors about whom very little was known. The private investor version of the

questionnaire was shorter and did not include questions regarding safeguards and regulations.

However, the institutional investor version of the questionnaire contained jargon and complex

questions. The final versions of both questionnaires comprised four sections: three addressed

one of the auditor-client relationships and one focused on respondent characteristics.

The first section of the questionnaire examined investor perceptions of long (over five years)

auditor-client relationships. The five-year horizon was chosen to represent a lengthy auditor-

client relationship, as currently in the UK audit engagement partners are required to rotate

every five years. Investors were asked to agree or disagree with the statement „a long

relationship (over five years) between an auditor and a client company is a threat to auditor

independence‟. The investors were also asked, „how would you rate the UK‟s current system

of partner rotation every five to seven years as a means of protecting auditor independence?‟

and „would the introduction of a system of mandatory audit firm rotation in the UK give you

greater confidence in the independence of auditors?‟ Those in favour of mandatory audit firm

rotation were also asked to explain their position.

The second section of the questionnaire examined perceptions of economic dependence.

Investors were asked to agree or disagree with the following statements: „before investing in

a company I consider the amount of audit fees the company pays to its auditor‟ and „I would

not invest in a company if I perceived its auditors to be economically dependent upon it‟.

The institutional investors were asked „the APB has imposed a 10% limit on income from

any one client as a safeguard to auditor independence. Do you believe this limit is: adequate,

not adequate or are you unsure?‟ Section three examined the issue of non-audit service

provision. Respondents were asked to indicate their agreement with the following statements:

„when investing in a company I consider the amount of non-audit services the company

employs from its auditor‟, „the provision of non-audit services to an existing audit client

affects my confidence in an auditor‟s ability to remain independent‟, „when one of the Big

Four accounting firms provides non-audit services to an audit client, I am confident in its

independence‟ and „when one of the smaller (non-Big Four) accounting firms provides non-

audit services to an audit client, I am confident in its independence‟. Investor perceptions of

individual non-audit services banned under the Sarbanes-Oxley Act were also explored.

Finally, in the institutional investor version of the questionnaire, perceptions of the

regulations on the provision of non-audit services were investigated. The respondents were

asked to indicate whether they were in favour of a prescribed audit/non-audit fee ratio,

strengthened audit committees, mandatory tendering of non-audit services, better justification

in annual reports of the need for non-audit services and granting shareholders greater powers

to be involved in the governance of companies. The final section of both questionnaires asked

respondents for personal information and asked respondents to indicate how thoroughly they

read the annual report before making investment decisions.

Since no complete list of institutional investors exists, taking a random sample of the entire

population was not feasible for the current study. Instead, 719 names and addresses of UK

chief executives were found by searching various databases of insurers, banks, building

societies, fund managers, pension funds and investment trusts and all 719 received a copy of

the questionnaire. The databases used to acquire names and addresses included those of the

Association of British Insurers, the Investment Management Association, the Association of

Investment Trust Companies, the British Bankers Association, the Building Societies

Association and the Council of Mortgage Lenders. Furthermore, various on-line lists of fund

managers and investment trusts were provided by the Financial Times, Find.co.uk, Finance

Link and Financial Express. The sample therefore represented a wide range of institutional

investors.

In order to provide a point of comparison with institutional investors‟ perceptions, certain

private investors were also targeted. The register of members for Amstrad plc and Jarvis plc

were obtained from Companies House. A random sample of 460 names (excluding

companies, institutional investors and nominee shareholdings) was taken for each company.

Response Rates and Tests for Bias

The questionnaires were sent out to the investors over the Summer of 2005. Two follow-up

letters were sent to the institutional investors and one follow-up letter was sent to the private

investors. Of the 719 questionnaires sent to institutional investors, 113 usable responses were

received, a response rate of 16%. Of the 920 questionnaires sent to the private investors, 254

usable responses were received - a response rate of 28%.

The results were tested for non-response bias using the approach advocated by Oppenheim

(1966) and Wallace and Mellor (1988) which takes late responses as a surrogate for non-

responses. A chi-square test was used to compare the responses to the main questions in each

section between the early and late respondents. No statistically significant relationship was

found. The tests suggest that the survey was not subject to non-response bias.

Analysis of Results

Table 1 outlines the characteristics of respondents. Institutional investors were predominantly

male (93.8%) and between the ages of 41 and 60 years old. Fifty eight point four percent

stated they possessed an accounting qualification and 47.8% of the sample had experience of

working within one of the Big Four accounting firms. Fourteen point two percent of the

respondents indicated that they had at one time been an auditor.

Of the private investor respondents, 78.7% were male, with the majority over 60 years old.

Only 15.1% of the sample possessed accounting qualifications and 85.7% of the sample had

no experience of working within an accounting firm at all. Only 1.6% stated that they had

once been an auditor.

Table 1 here

Descriptive Analysis

The perceptions of institutional and private investors of the three auditor-client relationships

are shown in Table 2. The respondents were asked to express their perceptions based on a

five point Likert scale ranging from strongly agree to strongly disagree, which was later

condensed to a three point scale for analysis.

Table 2 here

As the results in Table 2 indicate and in keeping with much of the previous literature, such as

Lindsay et al., (1987), Bartlett (1993), Beattie et al. (1999) and Alleyne and Devonish (2006),

both sets of investors are concerned about the effects of economic dependence. The majority

of both sets of investors indicated that they would not invest in a company if they perceived

the auditor to be dependent upon that company for its income. Results of a Chi-Square test

(Table 2) conducted separately upon the responses of private and institutional investors to the

following statement „I would not invest in a company if I perceived its auditors to be

economically dependent upon it‟ showed that in both cases there were statistically significant

differences between those who agreed with, disagreed with or were neutral towards the

statement. In examining auditing regulation, as can be seen from Table 2, 74.1% of

institutional investors perceived the 10% limit on fees from a listed client as a sufficient

safeguard of auditor independence. These findings support H1, because economic

dependence does negatively affect investor perceptions of auditor independence.

As with perceptions of economic dependence, the majority of both groups of investors (who

expressed an opinion) indicated that the provision of non-audit services caused concern in

relation to auditor independence. The results of the Chi-square test in Table 2 revealed that in

both the cases of the private and institutional investors the responses to the statement: „the

provision of non-audit services to an existing audit client affects my confidence in an

auditor‟s ability to remain independent‟, were statistically different between those who

agreed with, disagreed with or were neutral towards it. These findings support those of

previous UK perceptions-based studies conducted by Firth (1980) and Beattie et al., (1999)

who also reported that non-audit service provision caused concern amongst financial

statement users. Table 3 reports institutional investor perceptions of whether the individual

non-audit services banned under Sarbanes-Oxley detract from auditor independence. The

following were perceived to be independence-impairing: internal audit services (as also

reported by Titard, 1971), valuation of assets and liabilities, investment advice, bookkeeping

and actuarial services. In general, it appears that it is those non-audit services that involve the

auditor providing accounting-related services that seem to cause the most concern. Those

services which caused least concern were tax services (not banned under the Sarbanes-Oxley

Act, 2002, but found to affect investor perceptions by Mishra et al., 2005), human resources,

expert and legal services (in contrast to the findings of Quick and Warming-Rasmussen,

2005) and information systems design and implementation (also found by Titard, 1971 but in

contrast to the findings of Quick and Warming-Rasmussen, 2005). These results confirmed

the assertions of Mishra et al. (2005), who found that investor perceptions of individual non-

audit services varied. In all cases, except for information systems design and implementation,

Chi-square tests revealed that there were statistically significant differences between those

who thought the services detracted, did not detract or might possibly detract from an auditor‟s

independence.

Table 3 here

The results indicate support for H2, because the joint provision of audit and non-audit

services impairs auditor independence perceptions.

Interestingly, in accordance with the assertions of McKinley et al. (1985) and Gul (1989),

32.2% of institutional investors indicated that they would have confidence in the

independence of a Big Four accounting firm providing non-audit services to a client

company, but only 21.4% expressed confidence in smaller firms‟ independence.

Safeguards for auditor independence were also considered. The majority of both sets of

investors indicated that there should be a ban on audit personnel providing non-audit services,

but that there should not be a ban if a separate division of the same firm provides those

services.

Alternatives to a prohibition of non-audit service provision were put to the institutional

investors and are displayed in Table 4. The least preferable of the options was putting non-

audit work out to tender, 54.1% of institutional investors indicated that they would not be in

favour of such a system, whilst 50.5% of the sample of institutional investors also indicated

that they would not be in favour of a prescribed ratio of audit to non-audit services for

companies. Interestingly, 52.7% of the institutional investors were also not in favour of

giving shareholders greater power to intervene in the governance of companies. The

reluctance to be more active could be due to fear of assuming more responsibility and

liability. Institutional investors favoured lower cost options such as strengthening audit

committees (71.2% were in favour of this course of action) and 58.6% of institutional

investors were in favour of greater disclosure in annual reports of the need for non-audit

services. Chi-Square tests (reported in Table 4) revealed that for each of the options there

were statistically significant differences between those who were in favour, not in favour or

who were unsure of the alternatives to a prohibition on non-audit service provision.

Table 4 here

Finally, perceptions of long audit tenure were explored. The majority of both institutional and

private investors (who expressed an opinion) - 48.6% and 38.4%, respectively - disagreed

with the statement „a long relationship between an auditor and a client company is a threat to

auditor independence‟. Chi-Squared tests (reported in Table 2) revealed that there were

statistically significant differences between those who agreed, disagreed and who were

neutral towards the statement. These findings are similar to those recorded by Firth (1980 &

1981), Shockley (1981), and Hussey and Lan (2001). However, the results suggest that

private investors are more concerned about long tenure than institutional investors. It is

possible that in comparison to the assertions made by Firth (1981), institutional investors

actually view lengthier auditor-client relationships as advantageous. Similar to the assertions

of Alleyne and Devonish (2006), both groups of investors indicated that they perceived the

current regulations of partner rotation to be sufficient in protecting auditor independence.

However, in comparison to the findings of Baker et al. (2005) and Jennings et al. (2006)

almost half of the private investors were proponents of mandatory audit firm rotation as a

means for greater protection of investments.

These findings do not support H3, because long tenure does not appear to affect the majority

of investors‟ perceptions of auditor independence.

Exploring Relationships

Non-parametric Mann-Whitney tests were employed to explore the relationships between

perceptions of the three auditor-client relationships and the following independent variables:

QUALIFICATION – the respondent does or does not possess an accounting qualification

TYPE – the respondent is a private or an institutional investor

GENDER – the respondent is male or female

It was not possible to employ more powerful parametric tests as the dependent variables were

ordinal in nature. The dependent variables are made up of responses to the following main

questions:

TENURE - „A long relationship (over five years) between an auditor and a client

company is a threat to auditor independence‟,

ECONOMIC DEPENDENCE - „I would not invest in a company if I perceived its

auditors to be economically dependent upon it‟,

NON-AUDIT SERVICES - „The provision of non-audit services to an existing audit

client affects my confidence in an auditor‟s ability to remain independent‟.

Respondents were asked to indicate the extent to which they agreed with the above

statements based upon a five-point Likert scale where 1 = strongly disagree through to 5 =

strongly agree (this scale was condensed to a three-point scale for analysis). The results of a

Spearman‟s Rank Order Correlation test showed that the responses to these three questions

were positively correlated at the 0.01 significance level (respondents tended to agree with all

three statements or disagree with all three statements). Therefore, the respondents were

consistent in their views.

The results of the Mann-Whitney tests are outlined in Table 5:

Table 5 here

i) QUALIFICATION

In order to test H4 non-parametric tests were run to determine whether there existed a

relationship between a respondent‟s possession of an accounting qualification and that

respondent‟s perception of economic dependence, non-audit service provision and long

tenure. The results showed that, for the institutional investors, there were no statistically

significant differences between those with and those without accounting qualifications in

their perceptions of auditor independence. However, statistically significant relationships

between private investor perceptions of long tenure and economic dependence and the

QUALIFICATION variable were found. In each case, the mean rank of the „NO

QUALIFICATION‟ group was higher than the „QUALIFICATION‟ group, suggesting that

those without accounting qualifications were more concerned about the threat of long tenure

and economic dependence than those with qualifications. This confirms the earlier findings of

Reckers and Stagliano (1981). Furthermore, it provides evidence that those who are members

of the accounting profession appear, at least in some cases, to be more confident in their

colleagues‟ ability to remain independent than those who are not members of the profession,

(see Firth 1980, Beattie et al. 1999, Quick and Warming-Rasmussen, 2005).

However, although those private investors without accounting qualifications had a higher

mean level of concern for non-audit service provision than those with accounting

qualifications, the Mann-Whitney test was not significant. It is possible that due to the timing

of the survey (in the wake of the Enron scandal when the dangers of high levels of non-audit

service fees were well publicised) that all investors were concerned about this auditor-client

relationship, regardless of their understanding of accounting (as suggested by the results

reported in the descriptive analysis section).

One explanation for the QUALIFICATION variable‟s lack of effect upon institutional

investors‟ perceptions could be that even those who indicated that they had no accounting

qualifications may still have had a good understanding of accounting in their position as chief

executive (assuming that it was the chief executives themselves who responded). Therefore,

there may be fewer differences between a qualified and unqualified institutional investor in

terms of understanding of accounting than compared to a qualified and unqualified private

investor. The findings of these tests do not support H4, because differences exist between

investors with and without accounting qualifications in their perceptions of auditor

independence.

ii) TYPE

The Mann-Whitney test performed upon the TYPE dependent variable on the combined

(private and institutional) dataset revealed a statistically significant difference in perceptions

of long tenure and economic dependence between private and institutional investors. The

tests indicated that the private investor group had higher mean ranks in both cases than the

institutional investors, indicating that, unlike the assertions of Titard (1971), private investors

are more concerned about the effect of long tenure and economic dependence upon auditor

independence than institutional investors. Fewer of the private investors have accounting

qualifications, so this finding could be related to the QUALIFICATION finding.

Although a slightly higher mean level of concern was recorded for the private investors in

relation to non-audit service provision, this relationship was not significant. As argued

earlier, this finding might reflect a general concern amongst all investors regarding the

independence-impairing effects of non-audit service provision – this explanation seems the

most likely given the high levels of concern captured by the descriptive findings. These

findings do not support H5, because there are differences between private and institutional

investors in their perceptions of auditor independence.

iii) GENDER

H6 cannot be rejected, because the results of the Mann-Whitney tests suggest that there are

no statistically significant differences between men and women in their perceptions of auditor

independence.

Conclusions

A review of the literature and current UK regulations highlighted that economic dependence,

non-audit service provision and long tenure had the potential to damage auditor

independence. Concerns regarding auditor independence have once again arisen because of

the recent banking crisis in the UK. This study responds to the gap in the current auditor

independence literature by providing evidence on how well protected the owners of UK

organisations perceive themselves to be, by auditors and their current Ethical Standards, in

the wake of the US accounting scandals such as Enron and WorldCom.

This research started out with three main research hypotheses: that an auditors‟ economic

dependence upon its client, joint provision of audit and non-audit services by an auditor, and

client employment of the same auditor for over five years would all impair investor

perceptions of auditor independence. However, the survey results show that UK investors are

most concerned about the threats of economic dependence and non-audit service provision,

and are relatively unconcerned about the threat of long audit tenure. These findings are

consistent with similar UK studies conducted before the recent wave of audit failures and

audit market concentration (see Firth, 1980 & 1981 and Beattie et al., 1999).

In terms of auditor independence enhancement strategies, this research shows that the

majority of both sets of investors believe their investments to be protected by the APB‟s

„Ethical Standards for Auditors‟. Despite indicating some concern about economic

dependence and non-audit service provision, institutional investors indicated that the current

regulatory regime should not be changed. As suggested by Beattie et al. (2009), it is possible

that investors believe that the changes to regulations that were introduced by the APB after

the recent wave of US accounting scandals sufficiently addresses their concerns regarding

particular auditor-client relationships.

This study also tested three background hypotheses. These were whether there was a

difference between respondents with or without accounting qualifications, private and

institutional investor respondents and male and female respondents in their perceptions of

auditor independence. Results of non-parametric tests indicated that there is no difference

between men and women in their perceptions of auditor independence but that those without

accounting qualifications and private investors are more concerned about auditor

independence issues than those with accounting qualifications and institutional investors.

These unique findings imply that it is those who are less familiar with the issues addressed in

the study who are most concerned about auditor independence, which could be due to a lack

of understanding or information about the issues.

Finally, it is important to note that the current study is subject to some limitations. For

example, resource constraints meant that the perceptions of private investors were limited by

the use of just two medium-sized company shareholder registers. The study could be

extended and enhanced by sampling the perceptions of private investors from large and small

UK companies, thus improving the external validity of the findings. Furthermore, the

conclusions of the study are based upon data collected in 2005, which represent post-Enron

perceptions of auditor independence. Recent developments in the business environment, such

as the banking crisis, make it possible that investor perceptions have been subject to further

changes since the data were collected.

Despite these limitations, this study is the first in the UK to provide a comparison of

institutional and private investor perceptions of three controversial auditor-client

relationships. The study has also provided a timely investigation into investor perceptions of

UK auditing regulations. As investors are one of the main users of audited financial

information, it is important that they perceive auditors to be independent. Without such

confidence, a return to more stable economic conditions is likely to lie much further in the

future.

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Table 1 Respondent Characteristics Institutional Investors Private Investors

Characteristics % Number of

respondents

% Number of

respondents

Male 93.8 106 78.7 200

Female 6.2 7 21.3 54

TOTAL 100 113 100 254

With Accounting Qualifications 58.4 66 15.1 38

Without Accounting Qualifications 41.6 47 84.9 214

TOTAL 100 113 100 252

Experience in Accounting Firms: None 38.9 44 85.7 216

Experience in Accounting Firms: A Small

Firm

5.3 6 4.7 12

Experience in Accounting Firms: A Medium

Firm

8.0 9 3.6 9

Experience in Accounting Firms: Big Four 47.8 54 6.0 15

TOTAL 100 113 100 252

Age- Under 30 yrs 3.5 4 0.4 1

Age- 30-40 yrs 23.9 27 7.2 18

Age- 41-50 yrs 30.1 34 13.5 34

Age- 51-60 yrs 39.0 44 27.5 69

Age- Over 60 yrs 3.5 4 51.4 129

TOTAL 100 113 100 251

Employed previously as an auditor 14.2 16 1.6 4

Not employed previously as an auditor 85.8 97 98.4 248

TOTAL 100 113 100 252

Company Employs < 100 44.0 50 N/A N/A

Company Employs 100-250 18.0 20 N/A N/A

Company Employs 251-500 10.0 11 N/A N/A

Company Employs > 500 28.0 32 N/A N/A

TOTAL 100 113 N/A N/A

Mean Number of Companies Invested in: 259.8 N/A 24.0 N/A

Table 2 Descriptive Statistics % Institutional Investors % Private Investors

Disagree Neutral Agree Disagree Neutral Agree

I would not invest in a company if I perceived

its auditors to be economically dependent

upon it

20.7 26.1 53.1 5.2 22.6 68.3

Chi-

Square:

20.108

P value:

.000*

Chi-

Square: 145.167

P value:

.000*

It is possible for an audit firm to be

economically dependent upon a client and still

maintain its independence from that client

57.2 15.2

27.7 55.6 19 25.4

Audit fees alone could not cause an audit firm

to become economically dependent upon a

client

40.2 21.4 38.3 N/A N/A N/A

The 10% income limit is an adequate

safeguard for AI

13.4 12.5 74.1 N/A N/A N/A

The provision of NAS to an existing audit

client affects my confidence in an auditor‟s

ability to remain independent

30.4 26.8 42.9 18.5 39.4 42. 1

Chi-

Square:

4.786

P value:

.080***

Chi-

Square: 25.425

P value:

.000*

When one of the Big 4 accounting firms

provides NAS to an audit client, I am

confident in its independence

29.5 38.4 32. 2 N/A N/A N/A

When one of the non-big 4 accounting firms

provides NAS to an audit client, I am

confident of its independence

42 36.6 21.4 N/A N/A N/A

NAS should be banned if audit personnel

provide them

33.9 6.2 59.8 26.5 14.2 59.3

NAS should be banned if different personnel

provide them

83 5.4 11.6 55.3 20.9 23.7

A long relationship (over 5 years) between an

auditor and a client company is a threat to AI

48.6

33.3 18 38.4 35.2 26.4

Chi-

Square:

15.622

P value:

.000*

Chi-

Square: 5.792

P value:

.050**

Partner rotation is a sufficient safeguard of AI 20.5 2.7 70.5 15 8.3 68.4

Mandatory audit firm rotation should be

introduced

57.1 8 34.8 36.4 14.2 49.4

Table 3 Institutional Investor perceptions of individual non-audit services

DOES NOT

detract from an

auditor’s

independence (%)

Unsure whether this

detracts from

independence (%)

DOES detract

from an

auditor’s

independence

(%)

Chi –

Square

(P value)

Bookkeeping and other

accounting services

40.4 13.8 45.9 19.284

(.000)*

Information systems design

and implementation

41.8 26.4 31.8 4.055

(.132)

Valuation of assets/liabilities 30.0 16.4 53.6 23.473

(.000)*

Actuarial services 40.0 19.1 40.9 10.055

(.007)*

Internal audit services 28.2 13.6 58.2 34.055

(.000)*

Human resources, e.g.

recruitment

50.0 25.5 24.5 13.764

(.001)*

Investment advice 29.1 21.8 49.1 13.164

(.001)*

Legal services 42.7 26.4 30.9 4.709

(.095)***

Expert services e.g. providing

expert opinions

46.4 28.2 25.5 8.527

(.014)**

Tax services, e.g. tax

compliance and tax planning

65.5 21.8 12.7 52.436

(.000)*

Table 4 Institutional investor perceptions of non-audit service regulations

%In favour %Unsure %Not in

favour

Chi-

Square

(P Value)

Strengthened audit committees, with

greater disclosures in the annual report

71.2 17.1 11.7 72.000

(.000)*

Better justification in company in the

annual reports of the need for NAS

supplied by their auditors

58.6 18 23.4 32.270

(.000)*

Making it mandatory for companies to

put non-audit service work out to

tender

27.9 18 54.1 23.081

(.000)*

Giving shareholders greater power to

be involved in the governance of a

company

20.9 26.4 52.7 19.109

(.000)*

A prescribed maximum ratio of audit

to non-audit fees

31.5 18 50.5 17.676

(.000)*

Table 5 Mann-Whitney Tests INSTITUTIONAL INVESTORS PRIVATE INVESTORS

Mann-Whitney P-Value Mann-Whitney P-Value

QUALIFICATION

Economic

Dependence

1453.00 0.839 3323.00 0.050**

Non-audit service

provision

1438.00 0.617 3594.00 0.226

Long Audit Tenure 1415.50 0.660 3036.00 0.025**

GENDER

Economic

Dependence

Non-audit service

provision

Long Audit Tenure

200.00

272.00

267.00

0.112

0.529

0.215

4966.00

5091.00

5142.00

0.380

0.493

0.989

COMBINED DATASET

TYPE Mann-Whitney P-Value

Economic

Dependence

11401.00 0.002**

Non-audit service

provision

13280.50 0.285

Long Audit Tenure 11963.00 0.029**

Notes

N/A: Question not applicable to private investors

* Significant at the 0.01 level

** Significant at the 0.05 level

*** Significant at the 0.10 level